Forex Investment and Currency Trading

Forex markets function alongside other major financial markets, such as stocks, bonds, and commodities. Although these financial markets overlap to some degree, there are few reliable correlations between currencies and other markets on a short-term basis. The one financial market where there is a strong correlation to currency developments is the U.S. dollar index.

But there are still important fundamental and psychological relationships between other markets and currencies, especially the U.S. dollar. In that sense, we look to developments in other financial markets to see whether they confirm or contradict price moves in the dollar pairs. So even though there may not be a statistically reliable basis on which to trade currencies based on movements in other financial markets, you’ll be a step ahead if you keep an eye on the following other markets.

U.S. Treasury yields

U.S. government bond yields are a good indicator of the overall direction of U.S. interest rates and expectations. We focus on the benchmark ten-year Treasury-note yield as our interest rate to monitor. Rising yields tend to be dollar positive, and falling yields tend to be negative for the dollar. If yields are rising, but the dollar isn’t, it suggests that other factors are at work keeping the dollar down and that dollar bulls should be cautious. If yields are falling and the dollar is falling, too, you’re getting confirmation from the bond market of a negative U.S. dollar environment – lower interest rates.

Make sure you understand the reason for the bond yield’s movements, because it can suggest different interpretations. If it’s based on interest rate expectations – due to data or Fed comments, for instance – it’s more likely to reflect overall dollar direction. If it’s due to market uncertainty and a flight to quality – due to emerging market upheaval, for example – the impact on the U.S. dollar is less predictable. The larger the change in yields, the more important is the message that’s coming from the bond market. Yield changes of more than 3 to 4 basis points should get your attention.

Gold prices

Gold is typically viewed as an alternative currency to the U.S. dollar as well as a hedge against inflation and a safe-haven investment in times of geopolitical uncertainty. As such, gold prices tend to move in the opposite direction of the U.S. dollar overall, but the short-term correlations are unreliable. Gold is a relatively illiquid market and frequently takes its cues from the larger forex market, but gold is no stranger to gold-specific market gyrations.

Look for confirmation of the U.S. dollar direction in gold prices. If the dollar is rallying and gold is falling, for instance, it’s a good sign that the dollar’s gains are for real. If the dollar is rallying but gold is holding steady or even rising, the dollar’s strength looks more suspect. Remember: The short-term relationship between the U.S. dollar and gold is not conclusive in a statistically reliable way, but it may be a red flag, and you should be alert and monitor the situation more closely.

Oil

Oil gets a lot of press about supposed correlations to currencies, but they don’t hold any statistical water – at least not in the short term, where most FX trading takes place. Instead, look to oil price developments for what they suggest about interest rate expectations and relative economic growth. Higher oil prices tend to increase inflation pressures, which may lead to higher interest rates. At the same time, higher oil prices tend to reduce economic growth by undermining personal consumption. Between the two, oil’s impact on the growth outlook is more important due to the speed with which consumers react to changes in oil prices. Interest rate changes take longer. The U.S. economy is both the largest and the most oil-intensive economy, so the U.S. dollar tends to come under pressure when oil prices rise.

Stocks

There is very little correlation, long term or short term, between stock markets and currencies. But in certain cases where stock market movements are especially extreme, such as a multipercent daily rise or fall, the currency of the domestic stock market is likely to experience a knock-on effect. For example, if the Japanese Nikkei stock index rises or falls by 1 percent, the yen is unlikely to react one way or the other. But if the Nikkei drops by 2 percent to 5 percent in a session, the yen is going to come under selling pressure as a result. It’s all a matter of degree.